Because exchange-traded funds (ETFs) are typically passively managed and based on market index, ETFs tend to have lower overall fees as compared with many mutual funds.
In addition, the way ETFs are structured these funds typically generate fewer trades and thus the costs to run the fund (including applicable taxes) are also lower than mutual funds.
When it comes to calculating the cost of owning an exchange-traded fund (or ETF), an investor needs to factor in not just management fees and expense ratios, but also the costs associated with trading the ETFs.
Quick ETF Crash Course
An exchange-traded fund is a collection of dozens or even hundreds of securities such as stocks or bonds, that give an investor access to different companies within a single fund. ETFs can be a low-cost way to add diversification to a portfolio.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
How ETFs Work
Most ETFs are passive, which means they track an index. Their aim is to provide an investor with exposure to a particular segment of the market in an attempt to return the average for that market.
If there’s a type of investment that you want broad, diversified exposure to, there’s probably an ETF for it.
Though less popular, there are also actively managed ETFs, where a portfolio manager or group of analysts make decisions about what securities to buy and sell within the fund. Generally, these active funds will charge a higher fee than index ETFs, which are simply designed to track an index or segment of the market.
Some of the largest ETFs, reflect large swaths of the market as a whole, similar to index mutual funds (though there are some differences between index mutual funds and ETFs).
ETFs typically reflect formulas investment companies come up with to select stocks or other assets with certain characteristics that make sense in a portfolio. There are also ETFs for commodities and leveraged ETFs that can magnify gains — or losses.
ETF Costs
Like any business, an ETF typically has operational expenses, including management and marketing costs. These costs are passed on to the shareholders of the ETF and are expressed as a percentage called an expense ratio. But ETFs can include other fees and costs as well. Some are easier to find than others.
How Are ETF Fees Calculated?
Investment fees are calculated in a range of ways.
ETF Management Fees
ETFs carry management fees, which tend to cover the technical and intellectual work involved in selecting and managing assets in an ETF.
When you look up the fees of a given ETF, they are shown as a percentage of the ETFs daily assets. One benefit of many ETFs that’s reflected in their low management fees is the lack of what’s known as “management risk” — i.e. the potential losses that may be incurred owing to the guidance of a live portfolio manager.
The Expense Ratio
The overall set of fees for an ETF is known as the expense ratio or the ETF expense ratio. ETFs typically have an expense ratio of 0.05%.
An investor can determine the expense ratio by dividing the annual expenses of the investment by the fund’s total value, though the expense ratio is also typically found on the fund’s website. Knowing the expense ratio will help an investor understand exactly how much money they will spend investing in an ETF fund annually.
For example, if an investor puts $1,000 into an ETF that has an expense ratio of 0.2%, they will pay $20 in fees every year.
ETF Commission Fees
One benefit of ETFs is that you can trade them like any other asset you buy or sell on an exchange, such as a stock or a bond. But as with those assets, investors may be charged a commission when buying and selling ETFs.
Some brokers no longer charge commissions or specifically offer commission-free ETFs. But the availability of these depends on both the ETFs “sponsor” and the brokerage or platform used to buy and sell the funds.
How Are ETF Fees Deducted?
ETF fees are calculated as a percent of the ETFs net asset value, averaged out over a year. These ETF fees are not paid directly — you don’t write a check to the ETF sponsor to pay the management fees. Instead they’re deducted from the Net Asset Value (NAV) of the fund itself, taken directly from returns that could otherwise go to the investor.
The SEC offers an example of just how important fees are: “If an investor invested $10,000 in a fund that produced a 5% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years the investor could have roughly $19,612. But if the fund had expenses of only 0.5%, then the investor would end up with $24,002 — a 23% difference.”
💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.
ETF Fees vs Mutual Fund Fees
One fee advantage ETFs have over mutual funds is that ETFs don’t have a front-end load fee. This is an expense associated with the selling of mutual funds that incentivizes brokers to sell one over the other.
Generally speaking, both ETF fees and mutual fund fees have been dropping in recent years as investors move to more passive strategies and providers of these productions compete on providing the lowest cost investment.
That said, though there are exceptions, ETFs tend to be more passive and thus have lower funds. They also don’t have some of the sales costs associated with mutual funds and their intensive marketing apparatuses.
If an ETF tracks an index, buyers can easily compare one provider’s fund to another and select the one with the lowest fee. This process can drive management fees and charges down as providers compete for business.
The Takeaway
ETF fees can be relatively low compared to mutual funds, but as with any investment fees, it’s good to know the potential costs upfront. Knowing an ETF expense ratio and other potential costs can go a long way toward helping an investor understand their total costs for investing in the fund.
For long-term investors, understanding the costs associated with different securities is important as fees can eat into returns. You may want to consider your investment costs when setting up your portfolio.
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